2. The Demand Curve
Relationship between the quantity of a good that consumers are willing to buy and the price of the
good. Qd = Qd(P)
Law of Demand: All other things being equal (“ceteris paribus”) the quantity demanded of a good
falls when the price of that good rises. The demand curve slopes downward.
3. Factors Affecting the Demand Curve
Movement along the demand curve: Own price of the good. If price of the commodity in question
changes, then we observe movement along the demand curve.
Shifts in the Demand curve:
1. Changes in Tastes and Preferences: Other things remaining constant, favorable changes in the tastes and
preferences shift the demand curve to the right.
4. 2. Changes in the population of potential buyers: Own price remaining constant, an increase in the number of
buyers of the commodity shifts the demand curve to the right.
3. Changes in expected future prices: Own price remaining constant, an increase in the expected future price of
the commodity shifts the demand curve to the right.
4. Changes in the price of related goods.
Substitutes Complements
5. 5. Changes in Income: Own price remaining constant, an increase in the income of the consumer shifts the
demand curve to the right.
Normal Goods Inferior Goods
6. The Supply Curve
Relationship between the quantity of a good that producers are willing to sell and the price of
the good. Qs = Qs(P)
Law of Supply: Other things remaining constant, the higher the price of a commodity, the more firms
are able and willing to produce and sell. When cost of production falls firms can produce the same
quantity at a lower price. The supply curve is upward sloping.
7. Factors affecting the Supply Curve
Movement along the supply curve: Own price of the good. If price of the commodity in question
changes, then we observe movement along the supply curve.
Shifts in the Supply curve:
1. Changes in the cost of production: Own price remaining constant, if the cost of the inputs rise, the
producers will produce less at any given price. For example, rise in the wages of workers increases the
cost of production.
8. 2. Change in Technology: Own price remaining constant, if there is an improvement in the technology which
makes production of a commodity more economically efficient, then the supply curve shifts to the right.
3. Government policies: Own price remaining constant, if the government imposes tax on a commodity, then the
producers will produce less of the commodity, thus, shifting the supply curve to the left.
4. Change in the number of firms: Own price remaining constant, if the number of firms producing a commodity
increases, the supply curve shifts to the right.
5. Changes in expected future prices: Own price remaining constant, a decrease in the expected future price of the
commodity shifts the supply curve to the right.
9. The Market Equilibrium
Equilibrium is a situation in which there is no tendency for the market price and quantity of a
commodity to change. This occurs at the price where quantity demanded equals quantity supplied. At
this price, the amount that consumers wish to buy is exactly the same as the amount that producers wish
to sell.
Equilibrium occurs at a price of Rs.3. The equilibrium quantity is 8 slices of pizza. When the price is above the
equilibrium of $3, quantity supplied is greater than quantity demanded. Firms are unable to sell all they want to at that
price. There is an excess supply, and this surplus creates pressure for the price to fall. If the price is below equilibrium,
there is excess demand, and the shortage creates pressure for the price to rise. Only at the equilibrium price is there no
pressure for price to rise or fall.
Quantity Demanded Price Quantity Supplied
2 5 18
5 4 15
8 3 8
12 2 2
17 1 1
10. The demand and supply curves intersect at the market clearing price of Rs. 3.
11. Changes in Market Equilibrium
Case 1: Shifting of the Demand Curve only. Supply curve remaining unchanged. Suppose, there is an
increase in income. The consumers are willing to pay higher price and firms produce a greater
quantity. The market clears at a higher price P2 and a higher quantity Q2.
12. Case 2: Shifting of the Supply Curve only. Demand curve remaining unchanged.
Suppose, the cost of raw materials decreases. The firms can now produce higher quantities at lower
prices. The market clears at a lower price P1 and a higher quantity Q1.
13. Case 3: Shifting of both the Demand and Supply Curves
Suppose, the economy is recovering from a recession. There could be factors that change both the
demand and supply. Then, both the curves shift. The new equilibrium price and quantity depends on the
magnitude of the shifts.
14. Elasticities of Demand and Supply
Elasticity: Percentage change in one variable resulting from a 1 percent change in another. For example,
price elasticity of demand measures the sensitivity of quantity demanded to price changes.
𝐸𝑝 =
∆𝑄/𝑄
∆𝑃/𝑃
Price elasticity of a normal good is usually a negative number. When the price of a good increases, the
quantity demanded usually falls. However, we refer to the magnitude of price elasticity which is its
absolute size. So, if Ep = -4, we say that the elasticity is 4 in magnitude.
When the elasticity is greater than 1 in magnitude, we say the demand is price elastic since the
percentage change in quantity demanded exceeds the percentage change in price.
When the elasticity is less than 1 in magnitude, we say the demand is price inelastic since the percentage
change in quantity demanded is less than the percentage change in price.
What about the case when elasticity is equal to 1?
15. Point Elasticity of Demand Curve
Price elasticity of demand at a particular point on the demand curve.
For example, consider a linear demand curve: Q = a – bP
Here, b denotes the slope which is constant along the linear demand curve, but the elasticity will vary
in magnitude depending on the changes in price and quantity along the curve.
16. Example 1: Consider the following demand curve: P = 80 – 2Q
Calculate the own price elasticity of demand when price is Rs. 20, Rs. 40, and Rs. 60.
Solution: Step 1 Express the Q in terms of P. So, Q = 40 – ½.P
Step 2 Plug in the value of P and calculate Q at that point. When P = Rs.20, Q = 40 – 10 = 30
Step 3 Use the formula to calculate the own price elasticity of demand at P=20
𝐸𝑝 =
∆𝑄/𝑄
∆𝑃/𝑃
= (20/30). (-1/2) = -1/3
DIY for your own clarity.
Using the same process, calculate the elasticities at P=40 and P=60.
You should get Ep = -1 and Ep = -3 respectively.
17. Example 2: The equation for a demand curve is P=48–3Q. What is the elasticity in moving from a quantity of 5 to a
quantity of 6?
Solution: Step 1 Calculate the Price at Q1 = 5.
P1 = 48 – 15 = 33
Step 2 Calculate the Price at Q2 = 6
P2 = 48 – 18 = 30
Step 3 Calculate the change in Price and Quantity.
Q = (6-5) = 1 and P = (30-33) = -3
Step 4 Use the formula to calculate price elasticity of demand.
Ep = (33/5).(1/-3) = -2.2
18. Arc Elasticity of Demand
What if we want to calculate the price elasticity over some portion of the demand curve rather than just
choosing the initial and final price?
Use arc elasticity of demand which is calculated over a range of prices. We use the average price, P, and
average quantity, Q, in this case. The formula is given by:
𝐸𝑝 =
∆𝑄/𝑄
∆𝑃/𝑃
19. Other Demand Elasticities
Demand of a good may also be affected by the prices of other goods. For example, coke and pepsi may
easily be substitutes for each other. The demand for each depends on the price of the other.
The percentage change in the quantity demanded for a good that results from a 1 percent change in the
price of another related good is known as cross-price elasticity of demand.
𝐸𝑄𝑐𝑄𝑝
=
∆𝑄𝑐/𝑄𝑐
∆𝑃𝑝/𝑃𝑝
=
𝑃𝑝
𝑄𝑐
∆𝑄𝑐
∆𝑃𝑝
Where 𝑄𝑐 is the quantity of coke and 𝑃𝑝 is the price of pepsi.
In this example, the cross-price elasticity is positive because the goods are substitutes.
If the cross-price elasticity is negative, then the goods are complements. For instance, if the price of
petrol goes up, the demand for cars would reduce.
20. Income elasticity of demand: The percentage change in the quantity demanded, Q, resulting from a 1
percent change in income, I.
𝐸𝐼 =
∆𝑄/𝑄
∆𝐼/𝐼
For normal goods, income elasticity is positive, meaning, for 1 percent increase in income the quantity demanded of
the good also increases.
Price elasticity of Supply: The percentage change in quantity supplied resulting from a 1 percent
change in price. This elasticity is usually positive since a higher price gives producers an incentive to
increase output.
Two Special cases of price elasticity of demand:
• Infinitely elastic demand: Consumers will buy as much of a good as they can at a single price P* but
for any higher price Q falls to zero and for any lower price Q is infinite. The demand curve is
horizontal at P*.
• Completely inelastic demand: Consumers will buy a fixed quantity of a good regardless of its price.
The demand curve is vertical at Q*.
21. Solving Linear Economic Models for Market Equilibrium
Consider a market demand curve (Qd) represented by P = 80 – Q and the market supply curve (Qs) represented by P = 20 + 2Q.
Solve for equilibrium price and quantity.
Solution: Step 1 Set Qd = Qs
80 – Q = 20 + 2Q
=> 3Q = 60 => Q = 20 units
Step 2 Plug in the value of Q in any one of the equations to solve for P
P = 80 – 20 = Rs. 60
22. Consumer Surplus and Producer Surplus
Consumer Surplus: Difference between the maximum amount that a consumer is willing to pay for a
good and the amount that the consumer actually pays. It is measured by the area under the demand curve
and above the line representing the purchase price of the good.
Producer Surplus: Difference between the firm’s revenue and its total variable cost. It is measured as the
area below the market price and above the market supply curve.
23. Calculating CS and PS
Here, CS = (1/2). 20. 20 = Rs. 200
PS = (1/2). 20. 40 = Rs. 400
There is no deadweight loss and the total surplus is
at the maximum level.
CS
PS
24. Evaluating welfare effects of a government intervention in the market
We can determine gains and losses to consumers and producers by looking at price controls imposed by
the government.
Price ceiling: The government makes it illegal for producers to charge more than a ceiling price set below
the market clearing level. Producers are willing to produce less but consumers are willing to purchase
more. It creates excess demand in the market. For instance, Gasoline prices are sometimes fixed at a
lower level.
Price Floor: The government sets the price above the market clearing levels. In this case, the producers
are willing to produce and supply more but the consumers are willing to buy less, thus, creating excess
supply in the market. For instance, minimum support prices to the farmers.
Deadweight loss: Price controls result in a net loss of Total Surplus, known as the deadweight loss.
25. Evaluating gains and losses from price controls
• What are the effects on the consumer surplus and producer surplus when the government imposes a ceiling price? What
happens to the total surplus?
Before the ceiling price, CS = $90,000, PS = $90,000, and TS = $ 180,000
After the ceiling price, CS = $120,000, PS = $40,000, and TS = $ 160,000
There is a deadweight loss (DWL). The gain in CS is outweighed by the loss in PS from the ceiling price.
A change in quantity from the equilibrium value is the only thing that causes a DWL. Changes in price will cause transfers. A
part of the loss in PS is transferred to the consumers as CS here. While the two effects work together, it is important to be able
to distinguish between the two.
26. Effects of a Price Floor
What happens when the government decides to set a minimum wage policy? If the government sets a binding minimum
wage (price floor), it must be set above the equilibrium price.
Before the price floor, CS = $1500, PS = $1500, and TS = $ 3000
After the price floor, CS = $700, PS = $1900, and TS = $ 2600
There is a deadweight loss (DWL). This time the transfer takes place from the consumers (firms) to the producers
(workers).
27. Example 1. Consider the following market. Suppose that the equilibrium quantity is reduced from Q1 to Q2 units,
through the introduction of a price floor at P=10. Which of the following correctly describes the resulting decrease in
MARKET surplus?
a) Market surplus will decrease by a – c.
b) Market surplus will decrease by e + c.
c) Market surplus will decrease by a + b + e + c.
d) Market surplus will decrease by b – e.
28. 1. A price ceiling of P3 causes:
a) A deadweight loss triangle whose corners are ABC.
b) A deadweight loss triangle whose corners are ACD.
c) A deadweight loss triangle whose corners are BEC.
d) A deadweight loss triangle whose corners are CDE.
2. A price floor of P1 causes:
a) Excess demand equal to the distance AB.
b) Excess supply equal to the distance AB.
c) Excess supply equal to the distance DE.
d) Excess demand equal to the distance DE.
29.
30. Effects of Quantity Controls
A policy to reduce quantity is called a quota, where the government imposes restrictions on the number of goods bought and
sold.
The effect of a quota is same as that of a price floor. The only difference is that here, the government puts restrictions on
quantity and we observe a change in the price. The market is inefficient just like it was in case of the price controls. There is a
deadweight loss in this market as well.
31. Taxes and Subsidies
Suppose the government imposes taxes and provides subsidies in an economy. The burden of a tax and the benefits of a
subsidy depend on the elasticities of demand and supply. If the ratio of the elasticity of demand to the elasticity of supply
is small, the burden of the tax falls mainly on consumers. On the other hand, if the ratio of the elasticity of demand to the
elasticity of supply is large, the burden of the tax falls mainly on producers. Similarly, the benefit of a subsidy accrues
mostly to consumers (producers) if the ratio of the elasticity of demand to the elasticity of supply is small
(large).
If the government levies tax on the producers, it increases their marginal cost and shifts the supply curve upwards.
The initial equilibrium price and quantity before the tax were
$4 and 4 gallons respectively. After tax, the supply curve shifts
upward. The new equilibrium is created at P=$5 and Q=2 million barrels.
The producers now receive a price of $2 and pay $3 as tax to
the government. The consumers face $1 increase in the price
and respond by reducing quantity demanded.
32. What if the incidence of tax is levied on the consumers?
The demand curve which shows the willingness to pay of a consumer, shifts down since the consumer has to pay the taxes.
33. Effects of Tax policy on the Surplus
Before Tax
CS = $4 million, PS = $8 million, TS = $12 million
After Tax
CS = $1 million, PS = $2 million, GS = $6 million
TS = $9 million
The green portion in the figure is transferred from the
consumers and producers to the Government due the tax’s
effect on the price.
The Purple portion represents the DWL.
34. Transfers and Deadweight Loss due to a Tax
Impact of price change due to the tax levied:
Transfer from Consumers to Government: Area A
Transfer from Producers to Government: Area C
Impact of Quantity change due to tax levied:
Deadweight Loss.
Decrease in CS: Area B
Decrease in PS: Area D
A tax drives a wedge that increases the price consumers have to pay and decreases the price producers receive.
35. What happens when the government decides to provide subsidy? A subsidy is a benefit given by the government to groups or individuals,
usually in the form of a cash payment or a tax reduction.
A subsidy drives a wedge, decreasing the price consumers pay and increasing the price producers receive, with the government incurring
an expense.
PS increases by areas A and B.
CS increases by areas C and D.
GS reduces by areas A, B, C, D and E
Areas A, B, C and D are transferred from the
government to consumers and producers.
Area E is a deadweight loss from the policy.
36. Elasticity and Policy
For a more elastic market a price change causes a greater decrease in quantity therefore a policy in a more elastic market
will cause a greater deadweight loss.
As supply (demand) grows relatively more inelastic, producers (consumers) bear a greater burden of the tax.
As supply (demand) grows relatively more elastic, producers (consumers) bear a smaller burden of the tax.
